Residential Ground Leases

By David Tevlin

Housing affordability remains a major concern for home builders and homebuyers. One approach to cutting home prices already has a long history: the residential ground lease. By giving the builder a share of the anticipated future appreciation of the property, ground leasing can achieve the same results as a program such as the shared appreciation mortgage (SAM) but with few complexities.

How it Works

As with a commercial ground lease, a home builder can retain title to the underlying land while selling only the building to a homebuyer. Since land can represent 20% or more of the total cost, this substantially reduces the price of the home and the buyer’s down payment. Also, if the ground rent is less than the after-tax debt service on the financing the buyer would otherwise need, carrying costs also are reduced.

Ground rent usually is set as a percentage of the value of the land. The builder normally will value the land equal to its cost to him. This permits the builder to realize a normal profit on the sale of the building. However, in order to make the deal more attractive to the buyer, the builder can allocate a value to the land that is less than his cost in order to keep the initial rental as low as possible. Typically, ground rent will represent anywhere from eight percent to ten percent of the value of the land. Since the ground lease normally is for long-term, the builder will want to include an escalation formula. This can take several forms.

Periodic Escalation

From the builder’s point of view, the best approach is to have the rent adjust each year in accordance with the Consumer Price Index or some other index. Alternatively, the land can be reappraised every five or ten years with the rent equal to a specified percentage of the land value. However, this could impose a serious burden on the homebuyer, particularly if inflation accelerates in the next few years.

Fixed Rental for Initial Term

A second approach is to set a fixed ground rent for a number of years, after which the rent will increase in accordance with an outside index. The potential problem for the home buyer is that the ground rent could double or triple at the end of the fixed-rate term, unless increases are to be based on the initial value of the land.

Graduated Rental Payment

The most attractive approach for a homebuyer is a graduated rental beginning at a very low level (similar to a graduated payment mortgage) in order to keep initial carrying costs as low as possible.

Lease Term and Purchase Option

The term of a ground lease should always be at least as long as the expected life of the building and often as much as 99 years with renewal options. This assures the homeowner that the house can be sold at fair market value without the need to buy out the ground lease.

The buyer always is given the option to purchase the land, which usually is exercisable at any time and is assignable to a subsequent owner of the house. The option price initially will be equal to the cost allocated to the land by the builder. However, the option price is likely to increase annually by an amount that reflects the projected appreciation in the value of the land (if any). In this respect, the ground lease resembles a shared appreciation mortgage (SAM).

Leasehold Financing

A major concern for the purchaser of a home on leased land is whether a leasehold mortgage can be obtained. The bank or other lender is not likely to provide the loan unless the land is subordinated to the mortgage (so that the lender has some protection as in the case of a straight fee mortgage). In some cases, however, the lender may be willing to make a leasehold mortgage as long as the ground lease, and the option to purchase, are assignable in the event of a foreclosure on the building.

Ground Lease as Investments

A builder using the ground lease technique will end up holding a portfolio of building plots subject to leases. The builder has two alternatives at this point. One is to continue to hold the land, earning rental income that likely represents a below-market return on his investment. (However, he can anticipate future purchases by homebuyers and appreciated prices.) The other alternative for the builder is to sell a portfolio of building plots to a third-party investor at a discount in order to realize immediate cash. The investor might be a local syndicate that sees this type of holding as a secure and relatively high return investment.